Call to Congress: End Loophole for Tax on Elite

Now that Republicans control both houses of Congress, they need to show they can accomplish something, and President Obama has just two years to burnish his legacy. So the search is on for bipartisan consensus.

I have two suggestions: “tax reform” and “carried interest.”

Is there anyone who truly believes the current individual and corporate tax systems are efficient and fair and promote growth?

And six years into the Obama administration, and more than seven since legislation was introduced to end the favorable treatment of carried interest, it seems astonishing that it lives on as a multibillion-dollar tax windfall for an elite group of superwealthy hedge fund, venture capital and private equity managers.

“It’s an outrageous loophole,” Daniel Shaviro, a specialist in tax policy and professor at New York University Law School, said of the tax code’s treatment of carried interest. “No reputable person will say otherwise unless they’re getting paid.”

Carried interest is the share of any profits that partners in hedge funds, private equity firms and venture capital funds receive as compensation, on top of management fees. A common compensation formula is for managers to get 2 percent of the amount under management, in addition to 20 percent of any gains, which is carried interest. Under current tax law, carried interest is treated as a capital gain, subject to the top 20 percent capital gain tax rate plus a 3.8 percent surcharge to help pay for the Affordable Care Act, rather than as ordinary income that is subject to a top marginal tax rate of 39.6 percent.

But carried interest has always seemed much more like ordinary income to most people who have considered the issue. Carried interest is compensation for the services that managers provide, like identifying, analyzing, making and managing the partnership’s investments. There’s no requirement they contribute capital to receive the carried interest. The fact that the ultimate amount of compensation may not be known for years is no different from the kind of compensation received by many people who still have to pay ordinary income tax rates.

As Representative Sander M. Levin of Michigan, the ranking Democrat on the House Ways and Means Committee, put it in a statement after one of his many attempts to close the loophole: “Real estate agents only make money if they actually sell a house, no matter how hard they work. Authors receive a portion of their book’s profits. Waiters get tips based on the quality of service they provide. All of these people pay ordinary income tax rates on their compensation. Only private equity and other fund managers get to pay capital gains rates on their compensation.”

What’s at stake here, besides basic fairness, is billions of dollars in potential tax revenue. The Obama administration estimates that ending the break would generate an additional $15 billion over 10 years. Others put the number much higher. Victor Fleischer, a tax expert, law professor at the University of San Diego and a contributor to DealBook in The New York Times, estimates the number at $50 billion.

When I’ve pressed the issue with hedge fund managers, I’ve found that they privately admit that the favorable tax treatment isn’t justified by any policy benefits and isn’t fair, even while publicly defending it and lobbying to preserve it. One of the few who has come out publicly for reform is Fred Wilson, a partner at the venture capital partnership Union Square Ventures. “It’s time for asset managers to start paying their fair share of taxes,” he wrote on his blog, AVC, in 2010. “We are among the most highly compensated people in the world. And we’ve been getting a huge tax break for years. It’s not right.”

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Representative Dave Camp of Michigan has called for a change in the carried interest treatment as part of the comprehensive tax reform proposal he unveiled in February.CreditBrendan Smialowski/Agence France-Presse — Getty Images

Greg Mankiw, the Harvard professor and economist who advised the Republican presidential candidate Mitt Romney, told me flatly this week, “Much carried interest income is really compensation for labor services and should be treated as such.”

He’s hardly alone among economists. A nonpartisan survey conducted by the University of Michigan’s Office of Tax Policy Research and the National Tax Association last year found that 90 percent of National Tax Association members agreed that carried interest should be taxed as ordinary income.

President Obama has called for closing the carried interest loophole in every budget proposal, including this year’s, and legislation has been repeatedly introduced to treat carried interest like ordinary income. While Republicans in Congress (and some prominent Democrats) have consistently blocked these efforts, usually on grounds that they’re opposed to any tax increase, few have actually defended the provision.

Representative Paul Ryan of Wisconsin, in his tax reform proposal, proposed the elimination of loopholes to lower the overall tax rate, a so-called revenue-neutral approach that’s consistent with the Republican’s pledge not to raise taxes. While Mr. Ryan, the chairman of the House Budget Committee and Mr. Romney’s vice-presidential running mate, hasn’t said exactly which loopholes need to be plugged, it’s hard to imagine that any meaningful rate reduction could be achieved without changing the treatment of carried interest.

Representative Dave Camp, the Michigan Republican who is chairman of the House Ways and Means Committee, has gone the furthest among Republicans, and explicitly called for a change in the carried interest treatment to help finance lower overall rates as part of the comprehensive tax reform proposal he unveiled in February. Mr. Camp’s plan drew bipartisan praise, including from Howard Gleckman of the Tax Policy Center of the liberal-leaning Brookings Institution. Still, he was excoriated by the conservative American Spectator for his “capitulation” to President Obama on the issue.

This week, I spoke to Mr. Camp, who is cautiously optimistic that tax reform could be one of the signature achievements of the next Congress. “The leaders of both parties have been talking about what we can do, and every list has tax reform on it,” he said. “I know there’s a lot of member interest in this because tax reform is one of the ways we can drive the economy and make people’s lives better. That’s what this election was about.”

The congressman said he explicitly mentioned carried interest in his proposal, even though he knew it would set off opposition, because “this needs to be on the table.” He added: “We need to debate it and we need to do something about it. That’s why I put it in there.” He said many Republican members of Congress have privately told him they agree, and “even people in the industry agree we need reform, though they won’t say that publicly." He can afford to be more outspoken, since he didn’t run for re-election and will retire at the end of this congressional term.

Mr. Camp called on the Treasury to come forward with detailed proposals. “A lot of work has already been done on this,” he said. “We know the president’s overall framework, but we don’t have the details. Our plan is out there and it’s very detailed. There’s a lot we can negotiate. Let’s look for policies that will spur growth and are good for the country.”

Professor Fleischer said he believed that tax reform, and specifically, treating carried interest like ordinary income, “still has a real chance in Congress.” Though the beneficiaries of the carried interest loophole tend to be big political donors, “there’s no grass-roots support for the favorable treatment of carried interest,” he said. “The story of income inequality in the United States is driven by the top 1 percent of the 1 percent,” he said, "and these are the people who are benefiting from carried interest. They’re hedge fund managers on Wall Street, not the Bill Gateses and Mark Zuckerbergs of the world, who you want people to emulate. So you can imagine the left wing of the Democratic Party and the right wing of the Republican Party coming together on this, as an issue of Main Street versus Wall Street.”

Professor Shaviro said he was pessimistic about the chances for change, but he, too, thought tax reform and elimination of the carried interest loophole could be popular across party lines. “Given that it’s the superrich who benefit, you can imagine how symbolic this could be in the hands of a skilled orator,” he said.

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